Follow the Money for Inflation Monitoring

August 13, 2014 – The Bank of Canada (BoC) should carefully monitor the money supply to better predict inflation and track the effectiveness of its monetary policy, according to a new C.D. Howe Institute report. In “Money Still Matters: How the Bank of Canada Might Better Monitor Inflation,” author Mati Dubrovinsky suggests the BoC should also pay particular attention to the possibility that the public’s inflation expectations will shift below targeted inflation, and should be prepared to adjust policy if and when such a shift occurs.

“The strong association between the growth of the money supply and inflation during the period 1997 to 2008 – when inflation was at its target – indicates the importance of monitoring the growth of monetary aggregates,” states Dubrovinsky.

The BoC has managed to ensure with reasonable success, since 1995, that the prices of all goods and services have risen by about 2 percent a year – in line with the 2 percent inflation target. However, notwithstanding a recent increase, inflation has largely been below target since 2012. If the low inflation trend resumes, there is a danger that the expected inflation will fall as well, impacting firm and household behaviour.

To mitigate this risk, the BoC should monitor monetary aggregates and report their growth – actual and forecasted, says the author.

Additionally, the BoC should expand its monitoring of inflation expectations to include a survey of professional forecasters and households. The BoC currently surveys business inflation expectations and provides its own forecasts.

If and when the BoC finds that inflation expectations fall below target, based on various measures, it should ease the overnight rate or pursue a quantitative easing strategy, by directly injecting money into the economy.

The C. D. Howe Institute is an independent not-for-profit research institute whose mission is to raise living standards by fostering economically sound public policies. It is Canada’s trusted source of essential policy intelligence, distinguished by research that is nonpartisan, evidence-based and subject to definitive expert review. It is considered by many to be Canada’s most influential think tank.